Henes: Bankruptcy Works: Why Congress Should Consider Bankruptcy for States

Jonathan S. Henes|Partner, Kirkland HKSCKPVIamp; Ellis LLP

Friday, 21 Jan 2011 | 11:58 AM ETCNBC.com

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In 1975, New York City was on the brink of bankruptcy. The city lacked the cash to make municipal bond payments while continuing to pay for vital services and public retiree and healthcare benefits. The city was on the verge of defaulting on its municipal bonds. The city pursued three options: seeking aid from the federal government, negotiating a deal with its public unions or filing for bankruptcy. The federal government rebuffed the city’s request for a bailout. Faced with the option of a municipal bankruptcy, the unions agreed to invest $2.5 billion of their pension funds in municipal bonds, which were used to bail out the city. The union’s investment put the pensions of thousands of public employees and retirees at risk, but it enabled the city and the unions to avoid bankruptcy and positioned the city to build a strong, long-term fiscal foundation.

In short, New York City avoided bankruptcy because it had the option to file for bankruptcy.

Unlike New York City and other municipalities, states cannot file for bankruptcy.

Yet, today, states are in a similar or worse fiscal position than New York City in the 1970s.

Collectively, states have budget deficits of more than $130 billion, unfunded pension and healthcare plans of more than $1 trillion and billions of dollars of unpaid bills to public schools and universities, hospitals and social welfare programs. Also, municipal bond yields have risen to levels not seen since our economy was in the throes of the economic crisis.

States are in crisis and floundering to find a solution.

States are increasing taxes, cutting spending, selling state assets or increasing borrowing to achieve short-term solutions to their fiscal problems. But the fiscal problems are long term and structural. At some point, the problems will become overwhelming and place the states on the precipice of failure. Can Congress actually let a state fail? This is the conundrum. While states are too big to fail, they are too big to be bailed out. Without a bailout and without the ability to file for bankruptcy, it is entirely realistic that a state will default on its debts and fail - an event that would lead to a complete disruption of the capital markets. But, we can learn from experience. As the story of New York City’s 1975 fiscal resolution demonstrates, the mere option to file for bankruptcy will provide insolvent states with the tools and leverage needed to repair their fiscal house for the long run.

Congress should provide insolvent states with the ability to file for bankruptcy, but it’s potentially a politically dangerous move for a congressperson to utter the word “bankruptcy” in the context of the states. “Bankruptcy” conjures up harrowing images — services shutting down and chaos on the streets. Public unions and employees will view state bankruptcy legislation as an attack on their retirement and pension payments. The public needs to know that not only does bankruptcy work, it works well. It does not need to result in a loss of services; in fact, it may be what allows services to continue. The mere specter of bankruptcy may allow states and their unions to resolve issues without the states ever filing for bankruptcy. All parties will be incentivized to reach an out-of-court solution rather than risking a bankruptcy court-imposed resolution. It’s almost always true that a negotiated result is better than a court-imposed result.

Without the ability to file for bankruptcy, states lack a major tool to actually fix their problems and will be forced to rely on short-term fixes for long-term issues. Of course, when the short-term fixes run out - which may occur sooner than anticipated - a state will be out of options. The only real option will be to ask the federal government for a bail out, which will risk our entire economic foundation. Congress should provide the states with the option to file for bankruptcy and enable the states to design and implement a comprehensive plan for long-term fiscal health.

Jon Henes is a partner in the Restructuring Group of the law firm of Kirkland & Ellis. Jon's practice involves representing debtors (including portfolio, privately-held and public companies), creditors' committees and distressed investors (including hedge funds, private equity funds and companies) in acquisitions, restructurings and bankruptcy cases.